Bringing It All Back Home

By Michael BlandingPublished Apr 23, 2014

Research by associate professor Leslie Robinson shines some light into the “black box” of foreign earnings.

By the end of 2010, 90 percent firms in the S&P 500 owned and operated a subsidiary in a foreign country. Globalization in full flower, right? Yes, but it might not be so pretty for America’s tax revenue. With the increase in foreign business has come fears that offshore earnings will never come back to the U.S.—as with the recent controversy over Apple’s use of foreign entities to avoid paying taxes on $100 billion in profits and sales.

When overseas earnings are expected to be subject to U.S. tax, accounting rules generally require companies to include this tax as a liability on their balance sheets, decreasing their near-term profits. However, these rules provide an exception for earnings deemed by a company to be “permanently reinvested” abroad. “The intuition is that the actual tax will be paid so far out in the future that it’s too complicated to determine the appropriate amount of the expected liability today,” says Leslie Robinson, associate professor of business administration at Tuck.

Because permanently reinvested earnings (PREs) are exempt from the requirement to accrue a tax liability in the financial statements, industry observers worry that companies may be tempted to overstate their PREs to make their profits look better. But is that happening? Robinson addresses the question in a new working paper, “The Location, Composition, and Investment Implications of Permanently Reinvested Earnings,” written with colleagues Linda Krull of the University of Oregon and Jennifer Blouin of the University of Pennsylvania.

Companies are required to report so little about their overseas business that it’s difficult to ascertain their underlying motivation for asserting that their foreign earnings are PRE. “The notion of PREs is a bit of a black box to people,” says Robinson. “One firm may say earnings are PRE because they don’t want to accrue the tax liability, while another firm may have genuine long-term reinvestment plans.” Enforcement, therefore, is difficult.

Recently, however, the Securities and Exchange Commission has begun demanding PRE-heavy companies disclose the amount of cash they hold abroad. “They appear to believe, without having any evidence for it, that most companies are not genuine about the PRE assertion,” says Robinson. “The purpose of our paper was to try to provide evidence on this issue and state an opinion on whether the SEC’s action was warranted.”

Toward that end, the researchers studied a dataset from the Bureau of Economic Analysis that lists assets and earnings by companies in countries across the world. By comparing these numbers to a company’s PRE, they could tell more about how and where these earnings were actually being reinvested. They found that only 25 percent of PREs were invested in countries with tax havens. In addition, they learned that just 55 percent of PREs were held in cash—a far cry from assertions of critics who assumed the percentage was much higher. In fact, only 14 percent of funds, on average, were being stashed as cash in countries with tax havens. Moreover, more than a third of PREs is being reinvested in high-growth divisions of companies, where presumably it is growing a firm’s overseas business. Of course, some companies may still be misreporting those earnings, but the clear majority seems to be reporting them accurately. “Some firms have the wrong motivation, but I don’t think it’s quite as bad as some people think,” concludes Robinson.

And yet, another problem looms. When the researchers looked at firms’ internal capital markets, they found that companies with higher PREs were less able to fund domestic investment with foreign assets. “That suggests that the concern that cash is trapped abroad is somewhat warranted,” Robinson says, raising the worry that some of those earnings may be inappropriately identified.

Because of that, Robinson and her colleagues actually conclude that the SEC is justified in requesting more information about firms’ foreign cash. “We think that not only should they be disclosing the amount of foreign cash, but they should also be disclosing the amount of foreign cash with the PRE distinction applied to it. That’s the only way for investors to distinguish between firms that have great liquidity even though they have a lot of PREs, and those that don’t.”

Predictably, companies have complained that the new disclosure requirements are costly infringements on their business. But by providing evidence to support the SEC’s actions, Robinson and her colleagues make the disclosures more justifiable. At the same time, their findings push back against the criticisms of those who have painted all PREs as illegitimate “trapped cash.” “People who work in this area have fairly strong prior assumptions—thinking that firms are behaving so badly,” says Robinson. “Our findings weaken that assertion. Some firms may be behaving badly—but on average they are not.”